Mexico: The hope of a nation

Jan 1, 2013

The government of Enrique Peña Nieto has staked its political future on a big bet that it can push through radical economic reforms. Without quick successes, its gamble could unravel fast

In his first full day in office last December, Enrique
Peña Nieto performed a feat that had long eluded
politicians in Mexico: the country’s 46-year old
new president managed to forge a broad agreement across all
three major political parties for what the government hopes
will be a sweeping set of economic reforms.

That Peña Nieto had on day one proposed in his
so-called "Pact for Mexico" an ambitious list of measures was
bold enough.

But that he had won endorsements for his
government’s 95-point plan from across the
political divide was entirely new – and was
orchestrated for one chief purpose: to signal that
Mexico’s new leader has what it takes to overcome
the political paralysis that has prevented previous
administrations from tackling Mexico’s fundamental
economic problems.

In a masterful piece of political theater that day, the
former state governor – who had just returned his
centrist Institutional Revolutionary Party (PRI) to power after
12 years in opposition – had also sought to hammer
home the point that he is prepared to shake things up to bring
about the vital reforms needed to turn Mexico into one of the
world’s high-growth emerging markets.

Though these are early days yet, Peña
Nieto’s fledgling administration at the start of
its six-year term has so far surprised even the most hardened
cynics across the political spectrum. And his election has lent
vigor to an already upbeat mood in Latin America’s
second largest economy.

Mexico’s economy rebounded in 2010 from
recession the year before, growing by 5.5%, its fastest
expansion in a decade. In the two years since, it has reported
higher GDP growth than Brazil. Its expected 4% expansion last
year was spurred on in part by US export demand that has helped
insulate Mexico from ill winds from Europe and a slowdown in
Asia and other emerging markets.

"The conditions are all there for growth: there is huge
potential," says Gerardo Rodríguez, a deputy finance
minister in the last administration. "Credit penetration has
doubled in the past decade and has the potential to double
again the next decade."

He adds: "Mexico finds itself placed very well between high
yielding countries that as an investor you don’t
really want to hold and the low yielding countries that offer
less return. That makes it very appealing to investors."

On the up

Financial markets have taken heart. In early January,
Mexico’s IPC stock index was breaking record
highs; the sovereign, meanwhile, was able to sell $1.5 billion
in 30-year global bonds at the lowest ever cost, with a yield
of 4.19%. And the country’s Purchasing
Manufacturers’ Index (PMI), a measure of business
sentiment, itself reached a new record in December of 57.1.

The improving mood predates the elections: Mexico had
already won praise in recent years for having achieved relative
economic stability and growth in the midst of a protracted
global slump. This followed a decade in which its average
growth had languished at 1.7%. A major part of the apparent
turnaround has been a boost in relative competitiveness with
China, given a rise in latter’s labor costs and as
Mexico’s own manufacturing sector has moved up the
value chain.

But the speed of last year’s uptick in
sentiment also caught many off guard. "Everyone was taken by
surprise by the reversal in perceptions," says Alonso
García Tamés, head of public sector at Grupo
Financiero Banamex. "Fiscal and financial conscientiousness is
paying off, the value of having an open economy and vibrant
financial market is paying off."

He adds: "The stars are aligned for Mexico to become more
successful, all the elements are there to have a period of
solid growth."

Many now believe that Mexico has a good shot at boosting its
growth by some two percentage points a year so long as key
reforms, including of the tax system and energy sector,
succeed.

Opportunity knocks

In an exclusive interview with LatinFinance in December
– his first with any international or domestic print
media since taking office – Mexico’s
finance minister Luis Videgaray says that the Pact represents
"an opportunity" to finally push ahead with critical
reforms.

"It’s an opportunity because it’s
a broad political agreement to carry out some significant
changes in public policy, particularly in economic policy, to
make some changes that we all know need to be made: on the
fiscal side, in energy and in competition."

"The mandate is very clear," he adds. "It is to do all the
things that we need to do to have faster growth, stable growth
and for that growth to be something that is not only evident in
the macro variables but in the households and the domestic
economy."

The 44-year old Videgaray, who is widely considered the
president’s right hand man and who headed the
transition team before being given the finance portfolio,
served previously as the State of Mexico’s finance
minister during Peña Nieto’s five-year
tenure as governor, from 2005.

In that role, he was highly regarded for his management of
public finances: he was instrumental in helping the state win
an investment grade rating, having slashed public debt by 20%
and having boosted state revenues through a successful fiscal
reform – although, he stresses, revenues were doubled
without tax increases. "This was all about revenue efficiency,"
Videgaray says. "It’s just as important as having
a good fiscal reform to have true efficiency in revenue
collection."

Boosting tax revenues and increasing competition in the
energy sector are two key priorities of the new administration.
Mexico has the smallest non-oil tax take of any OECD country:
at 11% of GDP, it is on par with Pakistan and compares
unfavorably to Brazil, at 34%, or even the Latin American
average of 18.5%. Oil revenues, which account for a third of
the budget, are in decline.

Fiscal first

Videgaray says the fiscal reform must fulfil three goals: it
must be simple and enable competitiveness; it must be fair; and
it must encompass all levels of the state as a whole, including
states and municipalities. "The agreement is for this to happen
in the second semester [of this year]," he says.

The reform aims at improving the efficiency and fairness of
the tax spending systems, to make public finances more
transparent, and to boost domestic savings and investment, and
– so it’s hoped –
Mexico’s growth potential.

"Clearly this is not just a marginal twist in the fiscal
regime. We need to do a true overhaul of our fiscal structure
in order for this to be possible," he says. The government has
said it will review all taxes as part of a comprehensive
reform, though Videgaray has said no new taxes will be
introduced this year.

The Pact also includes a sweeping proposal for broadening
social security. "It’s based on the belief that we
need to create a more equal society," he says.

Indeed, part of the rationale for the fiscal reform is to
raise funds to pay for the new programs under the Pact,
including universal healthcare. "We need to give budgetary
support for this to happen and that’s where the
fiscal reform comes into play. We need to create a basic safety
net to make sure that all Mexicans have a minimum base of
benefits."

The vision is bold. As Luis de la Calle, managing director
at consultancy De La Calle, Madrazo, Mancera, and a former
undersecretary for international trade, puts it:
"They’ve essentially said, 'let’s
build a welfare state with our budget.’" But, he
adds, "the question is: how will they pay for it and how much
will it cost?"

Videgaray says it’s too soon to talk numbers.
The government is "not releasing any figures because it will
all depend on many components that are yet to be defined," he
says.

Some anecdotal estimates put the cost of such reforms
– creating a social safety net – at between
3-5% of GDP. The Center for Economic and Budgetary Research
(CIEP), a think tank, puts that figure at closer to 6% of
GDP.

Vito Tanzi, a former head of the IMF’s fiscal
affairs department, says there is no relevant historical
precedent for what Mexico is setting out to achieve; only the
US and Sweden have set up welfare systems from scratch, one in
the midst of the Great Depression, the other in the context of
a highly homogenous society. "Mexico is a very long way from
where they need to be if they want to have a welfare state,
even one like the US. They will have to have a major tax
reform," Tanzi says.

Too much to handle?

Tax reform is the key to getting the broader set of
proposals in the Pact done. The finance ministry has estimated
that revenue losses from special tax preferences, exemptions
and deductions averaged more than 5% of GDP annually in the
2003 – 2010 period.

While there is consensus that a tax reform could prove a
significant boost to Mexico’s economy, experts
worry both about the aim of using the proceeds to fund a
broadening of social security and the chances of success of the
fiscal reform itself.

Peña Nieto’s administration has, in
effect, wagered its political future on getting its broader set
of reforms done. Videgaray himself points out that 44 of the
goals in the Pact are "explicitly subject to a fiscal reform
happening." But the fear is that given the new
government’s dense legislative agenda, if one item
falls short others could falter – and turn a hopeful
proposition quickly into a losing bet. The risks, experts say,
are not trivial, given a modern history littered with fallen
dreams.

Some question the logic of the government’s
approach. "I would not have put the general principle of
universal social security as one of the first reforms to do,"
says Claudio Loser, a former director of the Western Hemisphere
department at the IMF. "The problem is that the costs are
significant. And if it’s not done with a tax
reform that is major, then I would say this is a very dangerous
game

"As a broad plan it sounds great if they do the fiscal
reform on the revenue side, but it is an extremely dangerous
course of action. This could be a major disappointment if they
don’t manage it well."

Others cast doubt on the presumed need to sell a high-stakes
fiscal reform that risks substantial amounts of political
capital up front and at a time when the macro picture appears
relatively sound.

Indeed, in recent years, Mexico had already strengthened its
fiscal framework, boosting the credibility of public finance
management – a fact that, among other things, has also
contributed to bringing down public debt to 36% of GDP.

"Mexico doesn’t have an urgent need to do a
fiscal reform to address a fiscal problem," says
Rodríguez. "Mexico doesn’t have a fiscal
problem."

But there is also the practical reality of trying to get a
deal through Congress and winning the buy-in of opposition
parties when push comes to shove. Any major tax reform would
also demand confronting vested interests head-on while
expending much political capital in doing so. Experts,
including Tanzi, say there are simpler ways to boost revenue,
such as increasing taxes on gasoline, political resistance
notwithstanding.

Moreover, with the oil price hovering between $90-$100 per
barrel, the urgency for pushing the tax reform may be naturally
diminished.

Change in climate

Videgaray points out that the political climate has changed
markedly with PRI’s return to power. "The
political environment I think is very constructive.
It’s a major innovation to have the opposition
parties approach the government and seal a pact to work
together on important and difficult matters."

The agreement on the Pact between the ruling PRI, the
conservative National Action Party (PAN), which governed for
the past 12 years, and the left-wing Party of the Democratic
Revolution (PRD), is widely seen as significant.

But Peña Nieto’s achievement in winning
the support of the other two major political parties may prove
to have been the easy part: the bulk of the
document’s proposals were seen as relatively
uncontroversial in broad form.

"All the problems that the government wants to solve have
long been seen as serious problems for Mexico. In this sense,
agreement on these points is almost a no-brainer," says Loser.
The hard part, he says, will be "fighting on the details."

"The task ahead is enormous," he adds.

De la Calle agrees: "When you start tampering with special
interest groups, that’s when you can run into
problems."

Mexico has struggled in recent years to make any meaningful
progress in fiscal reform. Although ironically, it was
Peña Nieto’s own party that was most
obstructive over its 12 years in opposition to the very reform
agenda his government is now pushing.

Says Luis Rubio, president of CIDAC, a consultancy in Mexico
City: "I have no doubt that the administration will come up
with ambitious reforms. The question is whether they will have
the power to push them through. It is the PRI and PRI-related
interests that have long been the issue.

"The PAN has been trying for 20 years to raise VAT but
failed. Will the PAN now play the same role today as the PRI
has played for the past decade, that is, to block reform?
What’s in it for the opposition?"

He adds: "It was Peña Nieto that blocked many of the
reforms himself. He dominated the Lower House [of Congress].
Will it now be payback time?"

Nevertheless, a growing consensus is that Peña
Nieto’s PRI might now be willing to back some of
the measures it obstructed when in opposition, including
extending the VAT to food and medicine.

Political ammunition

Moreover, the government has already notched up some
legislative successes and may yet have the wind in its
sails.

In the run up to the inauguration, congress passed a key
labor reform bill, steered by Peña Nieto. The government
then had a major success in December with the passage of an
education reform bill. The sweeping overhaul of the
country’s substandard educational system grants
the government, rather than the union, the power to hire and
fire teachers. But the development could also set the
government on a collision course with the unions.

Some have suggested the PRI’s failure to secure
a majority in Congress will stymie the reform agenda. But Rubio
says: "Peña Nieto’s greatest asset is the
fact that he doesn’t have a majority, so he will
have to convince people, he will need the support of the
opposition."

Energy overhaul

At the same time the government is pushing ahead with plans
to overhaul the energy sector and specifically state oil
company Pemex, which funds nearly a third of the federal
budget.

The energy company in recent years has experienced sharp
drops in output at its largest fields. Official estimates
suggest oil output will stagnate at 2.8 million barrels per day
(bpd) over then next decade without substantial new
investment.

But Pemex remains protected by a constitution that does not
allow private investment in the state monopoly.

Duncan Wood, director of the Mexico Institute at the Woodrow
Center, says that despite output having stabilized in recent
years, without fresh investment it could nevertheless decline
to 2.5 million bpd by the end of the decade, at a time when
domestic oil consumption is inching towards 2 million bpd.

"You’re looking at a very dangerous situation
as the largest oil field enters decline in the next few years.
If you don’t get mechanisms in place to replace
those fields, you’re looking at losing potentially
another half a million barrels per day," he says.

"It’s not a question of Mexico lacking oil,
it’s a question of Mexico not being able to
exploit the oil it has," adds Wood. "Pemex is ill equipped to
deal with the challenges of the modern energy sector." Such
challenges include tapping unconventional hydrocarbons,
including oil in Mexican deep waters and shale gas – a
prospect Wood and others say would prove a huge boost to the
competitiveness of Mexican manufacturing.

"The consequences of not achieving this reform are quite
dramatic," says Wood.

Peña Nieto’s predecessor Felipe
Calderón was unable to garner support to reform Pemex,
but nevertheless began the process of opening the state-run
industry to private investment.

Peña Nieto has said publicly that he is pursuing a
constitutional reform to allow for private investment in the
oil sector. Videgaray also acknowledges that foreign capital
and expertise are urgently needed to develop the sector,
though, like the president, he rules out privatization. "Pemex
needs to team with other players in the international energy
arena that can bring capital and expertise," he says.
"That’s the key of the reform, to allow Pemex to
partner with such players."

Wood is confident the government will push hard for a
meaningful constitutional reform. "I’m more
optimistic than I’ve been in 17 years in Mexico
that something meaningful is going to happen. I’m
absolutely 100% sure they’re going for an
ambitious reform. There’s a better chance of them
getting there at the current political juncture than at any
point over the last 20 years."

But he concedes that ultimately legislative success on other
fronts will be key. "Peña Nieto and the government need
to keep having legislative success in order to keep going. If
there is a hiccup, that will damage the future
possibilities."

Yes we can

Videgaray, like his boss, is adamant that both fiscal and
energy reform will be tackled in the coming year and he insists
his government is best placed to succeed where others have
failed.

Asked whether he thinks his government can convince its own
party to drop historical opposition to reforming Pemex and
opening up the energy sector, Videgaray says: "absolutely,
otherwise we wouldn’t be doing it."

Similarly, on fiscal reform, he says the case is
unambiguous. "All of us are alert to the importance of doing
this and to the cost of delaying a fiscal reform. The consensus
is much broader, that this is something that needs to be done,"
he says.

He adds that the political environment today is "very
constructive." "It’s a major innovation to have
the opposition parties approach the government and seal a pact
to work together on important and difficult matters," Videgaray
says. "The political environment will help significantly."

"It’s not only the opposition, it is society as
a whole that needs to understand why we need to enhance the
financial capacity of the government," he says.
"It’s not just 'we need to tax more because
we’re taxing more.’ It’s
that we need to do things that are good for Mexico and the
Mexican people. One of the tools will be the tax reform.
It’s not an end in itself."

What’s at stake

If Videgaray and Peña Nieto are right and the
political cards are stacked in their favor, the fruits of a
successful economic reform could be significant.

Loser says it would mean the difference between Mexico
growing at 6% a year and reaching advanced income status in
thirty years or facing annual growth of roughly 2% and
wallowing in mediocrity for a generation to come.

Ultimately, though, the administration is likely to only
have one shot at the reforms. "Peña Nieto and the PRI
know it’s their last chance. If they want to stay
in power, they will have to get the reforms done," says Rubio.
"I’m convinced that they will undertake many
reforms but then they will crash against the wall at some
point. Then we’ll see what they’re
really made of." LF

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